BY MICHAEL GREELEY 

 MEMORANDUM
To: The Not Faint of Heart
From: A Sympathetic Venture Capitalist
Re: The Fork in the Road

April 15, 2003 | In the past few columns, I have stated the obvious: Venture capital markets, while occasionally rational, are baffled by what to do with the bio-IT industry. Companies that seemed promising three years ago are struggling or closing down as they run out of funding. Yet new firms and talented entrepreneurs enter the market each week, seeking capital to launch the next latest and greatest bio-IT company.

The promise of new bio-IT tools continues to be seductive. But, the failure to sell gene targets for cash is real. So is the collateral impact on vendors. Outstanding scientists and entrepreneurs have developed powerful tools, but, unfortunately, the pharma customer is not purchasing them in any meaningful manner.

According to Mark Murcko, chief technology officer at Vertex Pharmaceuticals, "the belief in the late 1990s that discrete technologies were silver bullets was inherently too much of a reductionist approach ... It is not like manufacturing automobiles." Now those companies that developed bio-IT tools and databases in the late '90s are being forced to evolve to higher levels of services or move into very different lines of business.

Part of the problem is defining what a bio-IT company is. My comments are focused on those companies that sell to pharmas. These "upstream" companies have created enterprise solutions that are sold like traditional IT solutions as opposed to consumer or patient technologies. The issues facing "downstream" bio-IT vendors, while equally complex, are different, and I will address them in subsequent columns.

The venture capital fund flows as reported by VentureWire provide an interesting context (see "Follow the Money"). While more drug discovery companies were funded in 2002, the average size of the rounds more or less stayed flat; however, across all industries, round sizes decreased dramatically. In the informatics sector, both total dollars and round sizes fell precipitously. The tools sector also witnessed a correction.


Where Do We Go from Here? 
Despite too many companies being created in each category, we have yet to see a dramatic increase in M&A activity. In an attempt to redefine themselves, many bio-IT companies are considering evolving into other broad business models.

Source: VentureWire

The most evident transition is for companies to use their own proprietary tools and enter into drug discovery themselves. During the past few years, the venture community facilitated this transition, but venture capitalists are questioning this strategy. Drug discovery business models are enormously capital-intensive. Murcko says this evolution is "hard to do because the company that was built is inherently siloed, and getting royalties is very difficult unless you have very strong intellectual property around a specific target."

The second evolution is the transition to a hardware/software solutions provider, which may be accomplished through a series of acquisitions. Advances in sequencing, genotyping, and high-throughput screening are staggering, and many of these systems, which rely on proprietary software, are decreasing in price and increasing in functionality. Again, Murcko cautions that adopting this model "sounds good on paper, I can sketch it out on a white board, but the trick will be to find a collection of companies that help each other continually improve what they do."

Ordinarily, many venture capitalists are concerned by business models that appear to be so capital-intensive. Arguably, this second category will be less capital-intensive than the drug discovery pureplay and will be able to generate service and maintenance revenue streams in addition to hardware revenue. For many venture investors, this may be more palatable than traditional drug discovery business models with distant future royalty payments and the hope of a potentially enormous terminal value.

The third alternative is almost a "do-nothing" approach. A company that has burned through its capital can "hibernate" as a smaller, professional services firm with proprietary solutions to specific issues within pharma. Rather than continue with a big direct sales force and developing deep, comprehensive solutions, the company would become a scaled-back operation.

My fundamental premise is that the bio-IT sector will remain exciting and ultimately create attractive investment returns. That said, though, the early pioneers in the field are now having to operate from a position of relative weakness. However, as business models evolve, this will improve. As alternatives are considered, remember the advice of Yogi Berra: "When you come to the fork in the road, take it."

Michael A. Greeley is managing general partner of IDG Ventures, a global family of venture capital funds operating in North America, Europe, and Asia, with approximately $600 million under management. He can be reached at mgreeley@idgventures.com.